For a lot of investors planning for taxation can be quite impulsive.
The public provident fund (PPF), national savings certificate (NSC), infrastructure bonds and life insurance are obvious choices and the proportion is decided arbitrarily without much thought to asset allocation, the risk-return equation, the investment objective of the product and whether it matches your own and such other evaluative yardsticks.
While on the face of it, all fixed income instruments (PPF, NSC, infrastructure bonds) fall largely within the fixed income category, there are different features, dynamics, yields, lock-in periods associated with each tax-saving product.
Often investors tend to ignore the nuances and invest in a product for the wrong reasons.
Before you start planning for taxation, you must understand that at the end of the day, it is just another investment you are making.
All factors that are closely related to investments like the risk-return equation and asset allocation are also related to tax-planning.
To understand this better let us understand this with the help of an example.
Let us say you have Rs 100,000 and want to invest the amount to maximise returns within a reasonable risk limit.
You will take some concrete and decisive steps to achieve that investment objective. You will choose the right instrument, plan your asset allocation, understand the risk-return profile of the instrument and see if it matches your own.
At no stage will you deviate from the 'financial' course that you have chalked out for yourself and give vent to recklessness for short-term gains.
Likewise, when you have Rs 100,000 with the primary objective of investing for saving tax, all the factors outlined above like asset allocation, risk-return, etc hold good.
The only difference is while investing to save tax, you have a limited range of products and not the entire investment universe, so your options are restricted to that extent.
To understand how you can better allocate assets within the entire gamut of tax-saving instruments, we have divided the tax-paying community into three distinct age profiles.
The reason we have chosen age as the distinguishing criteria is because appetite for risk and, therefore, the expected return, flows largely from one's age -- lower the age, higher the risk appetite and the potential return.
If you are between 25-35 years of age:
- You are young and probably married, maybe even with kids. If you are the sole breadwinner in the family then your position in the family assumes even more importance.
You need to ensure that your dependents are not put at risk in your absence. Insurance is your most pressing need at this age.
While the lure of taxation need not be the real reason for taking life insurance, if you are getting tax benefits along the way why complain? How much insurance and what kind of insurance plans do you need to take?
That is something that is best laid out to you by your insurance consultant. But one thing is for sure, life insurance should form a large, if not the largest chunk of your investments for tax-saving.
This is because in the 25-35 age bracket the need is acute and remember insurance is bought best at a younger age when it is cheaper.
- Being young, you have time on your side and can take on some risk. That makes equities a very attractive investment option for you.
A product like a tax-saving mutual fund/an equity-linked savings scheme (ELSS) is something that fits very nicely into your risk profile. Invest up to the entire Rs 10,000 limit.
Again, it is the investor's good fortune that he can invest in equities and even get a tax rebate on it!
- You can put smaller amounts in PPF and NSC. However, of the two, NSC is preferable because the cut in the interest rate (which has been happening with alarming frequency and intensity over the years) applies to PPF with prospective effect.
In other words, if you have taken an NSC at 9 per cent coupon rate last year, you will continue to draw that interest amount even in this year despite a cut in interest rate to 8 per cent. On the other hand, had you invested in PPF at 9 per cent last year, you will now get 8 per cent after the rate cut this year.
- You can give a miss to infrastructure bonds. The yield is unattractive and you are better off paying tax and investing in debt funds with steady track records.
If you are between 35-45 years of age:
- At this age, you are probably insured, so there is a lower need on that front. However, the moot point is - are you adequately insured?
You probably got insured at a time when you had fewer needs, a conservative lifestyle and a lower salary. If this scenario has changed with more needs and a flamboyant lifestyle, you may need to step up the insurance amount so that you/your family can maintain this lifestyle comfortably in the future.
Again, you don't need the tax carrot to underscore the need for an enhanced insurance cover, but you could use that tax rebate.
- While you aren't exactly young, you aren't alarmingly old either. You can take equity exposure up to Rs 10,000 to get a kicker in your investments that only equities can provide.
- Our view on NSC and PPF remains the same. Invest moderately and prefer the latter to the former. Likewise prefer debt funds to infrastructure bonds.
If you are over 45 years of age:
- At 45 years or above, your insurance needs are probably taken care of already. If they aren't then, you can bridge the shortfall by taking some additional insurance after consulting your agent.
- You can invest in an ELSS provided you aren't too close to retirement (around 60 years), in which case the risk-return profile of the mutual fund scheme would work against your own.
- Again, you can invest some portion of your money in NSC as opposed to PPF. If you haven't exhausted the Rs 100,000 limit, that is not a cause for concern.
Pay the tax and invest in debt funds instead, which over a period of time will give you a better return and will compensate for the tax you have paid.
As we mentioned earlier, it is better to invest with the clarity and foresight of clocking long term growth as opposed to investing with the short-term benefit of saving tax.
Having read our recommended asset allocation for investing to save tax and our tips on the same, there are some important pointers for investors:
- Make sure you have exhausted the Rs 100,000 investment limit with your insurance needs first.
- ELSS can be considered depending on your age. If you are over 60 years you can give it a miss.
- NSC and PPF interest rates aren't sustainable over the long term given the existing yields on market-linked government securities. You can invest moderate amounts preferably in NSC.
- Infrastructure bonds can be ignored. Pay the tax instead and invest prudently in debt funds that have the potential to give you a higher return and be quite tax- efficient at the same time.
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Invest with prudence to maximise growth with saving tax is the secondary objective. If the tax-saving instruments cannot help you maximise growth, then pay the tax and invest in instruments that can help you maximise growth.
This article forms a part of Money Simplified -- Asset Allocation for Tax Saving Instruments, a free-to-download online guide from Personalfn. To download the entire guide, click here.
